Crowdfunding’s Big-Bang Moment

The crowdfunding service Kickstarter reached an important milestone last week. The company’s website reported that Kickstarter has now funded over 50,000 projects, with pledges coming from over 5,000,000 individual backers. Since its founding in 2009, Kickstarter has helped fledgling projects raise nearly $1 billion in donations.

But those impressive numbers may be eclipsed by a revolution in venture financing that is only being held back by final government approval: start-ups raising actual investment funds from individuals in exchange for equity or a share of profits.

Last week, the U.S. Securities and Exchange Commission took a major step toward allowing crowdfunded equity financing. In a 600-page proposed rulemaking, the SEC moved to implement key provisions of the 2012 Jumpstart our Business Startups Act (or JOBS Act). Passed by a large bi-partisan majority of Congress, the JOBS Act directed the agency to simplify many aspects of corporate fundraising and initial public offerings, and to enable individual investors to participate in equity campaigns for small startups.

How big a deal is this “democratization” of finance? In a recent HBR article, Paul Nunes and I introduced the term Big Bang Disruption to signify innovations that, thanks to rapidly advancing technology, come out of the box both better and cheaper than alternative solutions already in the marketplace. These upstarts don’t just bedevil incumbents — they blow them away. Crowdfunded equity financing has the potential to do that.

To understand why, consider how crowdfunding works today. Up until now, at least in the U.S., services such as Kickstarter (and others including Indiegogo and Rockethub) have operated on a donation model. Organizers determine a minimal level of funding they need to bring the project to fruition, and establish premiums associated with different levels of contribution. Backers promise to support proposed projects in exchange for the premiums, which become more generous as pledge levels go higher. If the project goal is reached, Kickstarter collects the pledges from backers, taking a 5% cut before turning over the proceeds to the organizers.

Tapping the power of the Internet, crowdfunding has proven wildly successful. Kickstarter funds everything from art to food to fashion, films, and hardware. I recently pledged $40 to support the development of the Polar stylus, a self-assembling modular pen made up largely of magnets. In exchange for my pledge, I will receive a silver-plated Polar pen from the start-up’s second production run. The compelling campaign video demonstrating the different ways the pen could be configured and used went viral. Polar’s Canadian organizers wanted to raise $14,000, but instead received pledges of over $500,000 from over 14,000 backers, all in a matter of weeks.

As Paul and I look into the forces driving Big Bang Disruption (as research for our forthcoming book), we see crowdfunding as a key element behind a dramatic change in research and development. The old approach, characterized by secretive and proprietary internal projects, is being challenged by a crowd-based model based on cloud computing, large-scale databases, and the exploding availability of off-the-shelf hardware and software components. New products, services, and companies are created virtually, build their supply chains in the cloud, and connect with early customers through social media.

Thanks to the growing use of these tools, the economic advantage of internal R&D over external efforts is being reversed in industry after industry. We call this the victory of “innovation by combine” over traditional “innovation by design.”

And that process has only begun. Note that the money collected today by crowdfunding sites in the U.S. must still be treated as a donation, not an investment. That’s because state and federal law prohibits companies from selling equity without complying with complex filing and reporting regulations. Capital campaigns must also exclude backers who do not satisfy the SEC’s definition of an “accredited investor,” who must have verified annual income of over $200,000 or net worth of $1 million.

It was due to an organized lobbying effort by the start-up community that Congress passed the JOBS Act, designed to reduce (though not eliminate) the obstacles and precautions that limit start-up investment. The new law’s goal was to restart the stalled U.S. economy by removing excessive restrictions on investment in innovative start-ups. The SEC was ordered to develop new simplified rules for the sale of equity in companies looking to raise relatively small amounts, and to expand the potential base of investors beyond professionals.

And it is only now, after considerable delay, that the SEC has published its proposed rules. Under the new rules, which could go into effect as soon as early 2014, companies whose stock is not already registered can raise up to $1 million during any 12-month period with minimal filing and reporting. Individuals with annual incomes over $100,000 could invest up to 10% of their annual income or net worth each year, or 5% for those with incomes under $100,000. Investments must be coordinated through registered broker-dealers or “funding portals,” a new kind of online investment service that will be regulated by the Financial Industry Regulatory Authority.

Writing at the time of the JOBS Act’s passage last year, Google VP for Corporate Development David Lawee applauded the new law, noting that “Everyone can be an entrepreneur, and thanks to the passage of the JOBS Act, everyone can be an investor.” (Google was an active supporter of the bill’s passage.)

Lawee and others have emphasized the need to use technology to implement the new rules in ways that maintain trust and accountability without introducing unnecessary red tape. Citing the example of eBay, Lawee pointed to the potential of a similar “sophisticated rating system” for buyers and sellers that could implement the JOBS Act “in ways that allow new systems of trust, accountability, and cooperation to flourish.”

Existing broker-dealers may step in to coordinate the new investment rules. Or, today’s growing crowdfunding services may adapt their models to satisfy the SEC’s requirements and become “funding portals.” (Kickstarter has not indicated whether it plans to take advantage of the SEC rules once they are final. The company did not respond to a request for comment.)

New service providers may also emerge to build investment businesses around the JOBS Act’s crowdfunding provisions. The industry has at least one trade group, the National Crowdfunding Association, which hailed last week’s release from the SEC.

Today’s crowdfunding services have already put pressure on traditional approaches to raising money for new ventures, an aspect of entrepreneurship long dominated by professional venture capitalists, angel investors, and corporate partners. The freedom to innovate unleashed by the JOBS Act may prove far more disruptive, perhaps challenging the wildly successful models of today’s donation-based services.

It may fall to a new generation of disruptive innovators to usher in the era of crowd-based investment. If so, it will be another example of regulatory change that unleashes the power of technology to remake industry — or potentially in this case, to remake all of them.

Postscript: In response to my inquiry, a spokesperson for Kickstarter said the company does not plan to take advantage of the new rules to allow campaigns to sell equity.